Greece: Back from the Brink?

Amid the turmoil in Greece this past week, I have held several meetings with our investment teams to assess the implications of a possible default on Greek debt. Previously, my assessment was that the leading creditor countries – most notably Germany and France -- and the troubled sovereign borrowers -- Greece, Ireland and Portugal -- would strike agreements that postponed the day of reckoning when private bondholders would have to take losses on their investments. This premise was called into question, however, when protesters nearly brought down the Greek government, raising the specter of an imminent default.

The German Government’s announcement on Friday that private bondholders would not be forced to restructure Greece’s debt increases enhances prospects for a new bailout package. However, I am not confident that a debt crisis can be postponed indefinitely. Therefore, we are weighing the possibility that a Greek default could become a financial market event. While I do not believe this portends another Lehman Brothers financial crisis, we are prepared for a worsening of the euro-zone crisis.

The Unraveling in Greece

Before delving into the ramifications of a Greek default, it’s important to understand what happened to bring the country to the breaking point this past week. Recall that one year ago the Greek Government received a 110 billion euro ($155 billion) loan package from the European Union (EU) and IMF so it would not have to tap private capital markets until 2012-2013. Meanwhile, economic conditions in the country deteriorated, and revised forecasts indicated additional infusions of capital are required to cover Greece’s obligations over the next few years.

On the creditors’ side, the various parties involved were divided about how to proceed. The German Government wanted to involve the private sector in a restructuring of Greece’s debt, whereas the European Central Bank (ECB) was opposed on grounds that it could cause the rating agencies to declare Greece was in default.

Amid these developments, protesters in Greece staged a national strike last week against increased austerity measures that included cutbacks in government programs, increased taxes and privatization of various government run entities. Prime Minister Papandreou responded by announcing he would try to form a government of national unity that would include representatives from the opposition parties. These developments, in turn, set off a chain of events in which Standard & Poor’s downgraded all Greek banks from B to CCC, while Moody’s placed three French banks with significant exposure to Greece on review for possible ratings downgrades.

By week’s end, the crisis atmosphere lessened in response to two developments. The most important was German Chancellor Merkel’s retreat from earlier demands that private financial institutions would be pressured to restructure Greek debt. (Private creditors are expected to maintain existing exposures and to roll-over maturing debt voluntarily.) The second development was Greek Prime Minister’s Papandreou appointment of a new Finance Minister, and the pledge that the Greek Government would proceed with plans to pass a new austerity budget.

Market Response: Greek Default is Inevitable

While the latter developments lessen the risk of an imminent default, market participants are skeptical that Greece can work its way out of its problems: Yields on two year government debt have surged to 26%, and the credit default swaps market is pricing in an 85% probability of default over the next five years.

The market’s skepticism is well-founded. By next year, the IMF is projecting that Greece’s government debt outstanding will approach 160% of GDP. This level is substantially above the 90% threshold that Professors Rogoff and Reinhart identify where debt crises become common. (See their book This Time Is Different.) Second, the rate of unemployment in Greece has soared over the past year and is now approaching 16%. Assuming the government embarks on additional austerity measures, unemployment is bound to continue rising as the Greek economy contracts. Consequently, Greece cannot grow its way out of its problems.

If that is the case, why won’t the various creditors accept the inevitable and grant some form of debt relief?

The reason is that officials are worried about the precedent it would set and the consequences that could ensue. The primary worry is that the rating agencies would treat a restructuring of debt owed to the private sector as a default. This, in turn, could lead to a collapse of Greece’s banking system, which could spill over to other countries – notably Ireland, Portugal and possibly Spain.

Rather than to test the waters now, creditors prefer to stretch out events as long as they can, which some observers have called “kicking the can down the road.” The rationale of this approach is that it buys time for Greece to reduce its budget deficit and for European banks to bolster their balance sheets. (Note: this was also the strategy creditor governments took during the developing country debt crisis in the 1980s, when banks were allowed to keep loans on their books at par for roughly five years before they wrote them down.)

Consequences of a Default

While the creditors would like to postpone the day of reckoning, the events of the past week indicate that they may not have a choice if the electorate in Greece rejects the new austerity program. In that event, the borrower – rather than the creditor – would determine the timing.

In these circumstances, my prior assumption – that default was unlikely until at least 2013 – was no longer valid. Therefore, I have been huddling with our investment teams to consider what the consequences of a default would be and whether it could trigger a run on the European banks.

In weighing this possibility, we recognize there are some valid reasons why the crisis in Greece may be contained:

Greece is a small country and its links to the global financial system are limited. Government debt outstanding, for example, is roughly $450 billion, and the biggest owners of Greek bonds are European banks. Their holding of Greek paper totals $175 billion, which is less than 1% of their assets.

There is reasonable transparency about the debt obligations of Greece and other European sovereign borrowers and the problems are well understood. Consequently, it is less likely there will be a series of surprise developments such as preceded the financial crisis in the U.S.

The establishment of a European Financial Stability Facility (EFSF) to provide temporary financing for troubled borrowers and plans for a permanent rescue fund to be launched in mid-2013 should be sufficient to address the needs of the Greece, Ireland and Portugal.

The counter-argument is that a default by Greece would increase the likelihood of Ireland and Portugal seeking debt relief, and this would trigger a run on banks. If banks cut positions in the inter-bank market, it could result in a credit crunch such as occurred after Lehman’s collapse. In this regard, a report by Fitch indicated that 44% of prime money market funds in the U.S. were invested in short-term debt of European banks. Also, the President of the Federal Reserve Bank of Boston recently warned that, in the event of a default in Europe, there was a Lehman-like risk if panicky investors pulled their money out all at once.

Others have pointed out that U.S. institutions also have indirect exposure by underwriting credit default swaps on Greek paper. (According to one report, if one includes CDS into the tally, U.S. banks exposure to Greece increases from $7 billion to $41 billion.) While the overall exposure of U.S. banks to Greek, Irish and Portuguese banks is fairly modest, the inclusion of Spanish or Italian banks would make a difference, especially given their sizable global presence and inter-connectedness. Therefore, it is imperative for the EU to prevent the crisis from spreading to Spain and Italy.

Our Response: Heightened Alert

Weighing these considerations, I do not believe we are headed for a replay of the financial crisis post Lehman: The size, scope and lack of transparency of the European debt problems are not the same order of magnitude. That said, the risk of a European financial crisis has increased, mainly because it is very difficult for the trouble countries to grow their way out of their problems. In these circumstances, it is questionable how long they will accept austerity and how effective the creditors will be in maintaining their coalition.

Accordingly, we have responded by heightening our surveillance of the situation and by mapping out possible strategies. At present we do not have any direct exposure to the troubled sovereigns, and our exposure to banks in these countries or to those with significant exposure to them is small.

The relevant consideration for us is whether to maintain positions in risk assets such as equities and high yield bonds should the problems in Europe deepen. Thus far, we have pared back some risk positions in response to a slowing of the U.S. economy, but we have not altered our investment strategies because of the crisis in Greece. Meanwhile, we await the outcome of the negotiations between the EU/IMF and Greece, and we are monitoring conditions in the inter-bank market in Europe.

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